What is inflation accounting?

In the U.S., inflation accounting has resulted in optional supplementary disclosures on the effects of 1) general inflation, and 2) changes in the prices of specific types of assets. In other words, the main financial statements continue to report only the traditional, historical cost amounts without any adjustment for changing prices. [During the years 1979 to 1985, some supplementary disclosures on the effects of changing prices had to be included in the notes to the financial statements of the very large U.S. corporations. From 1986 until today, the supplementary disclosures are optional. Hence, the disclosures are not likely to be made.]

One reason that inflation accounting is now optional for U.S. corporations is that the U.S. inflation rate has been modest or low since 1983. Another reason is the belief that the cost of computing the disclosure amounts will be greater than the benefit to the readers of the financial statements.

To illustrate the logic of inflation accounting, let's assume that the general inflation rate and the changes in the costs of specific assets are increasing at a constant rate of 10% each year. This means that a power plant built for a cost of $1 billion will cost $10 billion at the end of a useful life of 25 years. By computing straight-line depreciation based on the historical cost, the income statement will report depreciation expense of $40 million per year ($1 billion/25 years). Obviously this is much lower than the current cost of the productive capacity being used up each year.

Similarly, if a retailer's cost of items in inventory is increasing at an annual rate of 10%, the cost of goods sold reported on the income statement (based on historical costs) will be less than the cost the company will spend in order to replace the units sold.

The use of historical costs during periods of increasing prices means that companies with large amounts of plant assets and inventory will be reporting net income that is greater than the true economic profit. As a result, the reported net income during inflationary periods is said to include illusory profit.